More Tips From TIPS

Aug.29.12 | About: iShares TIPS (TIP)

On April 20th, I wrote an article entitled: "Tips from TIPS: Implications for Bond Investors" after the U.S. Treasury's historic auction of five-year Treasury Inflation-Protected Securities at a record low yield of negative 1.08%. My takeaway from this auction and the TIPS curve was that holders of TIPS were pricing in a breakeven inflation rate that was higher than the yield on nominal Treasury securities through ten years, and that this forecast could signal trouble ahead for holders of high quality fixed income instruments. Investors were bidding up TIPS to prices that implied a negative real return to ten-year Treasury bonds for the coming decade.

Mocking my warning, the price of TIPS have continued to defy gravity, rising in value over the last four months with the most recent auction of five-year TIPS yielding a new record low of negative 1.29%, the sixth consecutive auction with a negative yield. Despite the almost non-existent coupon on TIPS, the $23 billion capitalization iShares Barclays U.S. Treasury Inflation Protected Securities Fund (NYSEARCA:TIP) returned 1.07% since the original article was published.

For readers unfamiliar with TIPS, Treasury Inflation-Protected Securities are government bonds whose principal is adjusted by changes in the Consumer Price Index. When inflation is present and the price index is rising, the principal increases at the same rate as this price index, providing an inflation hedge. When the principal grows, interest payments also grow because they are set at a fixed percentage of the principal. Last week's notable issuance was a re-opening of the prior five-year inflation-protected security paying a 0.125% coupon. The tap of this prior issuance priced at $107.85. Novice fixed income investors occasionally get understandably confused by the meaning behind a negative yield. Investors bought a bond for $107.85 that will pay them 0.125% per year for the next five years. If inflation is zero over the next five years, the sum of principal at maturity and the coupon payments will be less than the initial premium outlay, which is why the yield is negative.

5-Yr Treasury and 5-Yr TIPS Trailing 5 Years

Click to enlarge

Source: Bloomberg, U.S. Treasury

With the nominal five-year U.S. Treasury note yielding 0.71%, the negative 1.25% TIPS yield (both graphed above) implies a breakeven inflation rate of 1.96% on average over the next five years. If this embedded inflation forecast proves prescient, holders of nominal 5-yr Treasuries will earn a real return of negative 1.25% per annum (0.71% nominal return - 1.96% inflation). I wrote in my first article on TIPS, that this has important implications for high quality fixed income investors who should consider moving down in quality to BB-bonds (after the September swoon) to earn additional spread, or even rotate into equities that can pass through inflation costs as better ways to offset the risk of rising prices. While TIPS have performed well over the last four months and hit new record negative yields as prices have moved higher, high yield bonds and equities have both outperformed with the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) returning 1.78% and the S&P 500 (SPY, IVV) returning 2.58%. With almost twice as many dollars invested in TIP than JNK, some investors may need to look to rotate their fixed income allocation in coming months. While my readers know that I closely follow momentum, TIPS will not continue to hit new record low yields indefinitely.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.